A dynamic AD--AS analysis of the UK economy, 2002-2010.

In their Modern Principles of Macroeconomics textbook, Tyler Cowen and Alex Tabarrok introduce a dynamic version of the aggregate demand-aggregate supply (AD--AS) model. (1) It is a simple framework to make sense of economic shocks and policy responses. Its main difference from the traditional AD--AS model is that instead of showing the price level and real GDP on the two axes, the dynamic version shows inflation (on the Y axis) and real GDP growth (on the X axis), making the analysis much more accessible to students for two reasons. First, in a world of sustained inflation, it can be confusing to model declines in aggregate demand as leading to a fall in the price level. Second, inflation and growth are the main economic indicators discussed in the news--after all, inflation targets tend to be 2 percent, and recessions are defined as two quarters of negative GDP growth. Therefore, the dynamic model allows students to instantly draw upon their existing knowledge of the main economic indicators. (2) This article will discuss how it can be used to illustrate movements in the UK economy from 2002 through 2010. (3)

The UK Case Study (2002-2010)

The following text can be used directly with students, who are required to identify which curve(s) will shift and draw the new diagram. The solution (i.e., the graph) can be revealed alongside the actual data (see appendix).

Instruction 1: Your task is to depict the following shocks to the UK economy using the dynamic AD--AS model. The starting point is the first quarter of 2002. The "Great Moderation" is occurring, where productivity gains and the emergence of China and India as trading partners have created a relatively high potential growth rate. Real GDP growth is 2.2 percent, which you can treat as being equal to the Solow rate. (4) Inflation is in line with expectations, and indeed inflation expectations remain stable throughout the entire analysis. (5) The money supply is growing at 7 percent, and V is falling by 2.4 percent.

Draw the dynamic AD--AS model, identify the inflation rate, and label the starting position point A. (Figure 1 shows what the graph should look like.)

[FIGURE 1 OMITTED]

Instruction 2: In August 2005, the Bank of England's Monetary Policy Committee (MPC) cut interest rates from 4.75 percent to 4.5 percent, and this cut preceded an increase in the growth rate of the broad money supply. Despite some economists flagging the dangers of double-digit growth in broad money at the time, (6) because inflationary pressures weren't evident in CPI figures, the MPC turned a blind eye to it. This period also saw an increase in the growth rate of government spending. In 2002, government spending accounted for around 36 percent of GDP, but by 2007 it was 39 percent. (7) By Q4 2007, the economy was growing at 3.1 percent and inflation had risen to 2.8 percent. (8) Draw an updated graph and label the new situation point B. (Figure 2 shows what the graph should look like.)